Journal of Economic Perspectives—Volume 23, Number 1—Winter 2009 —Pages 51–75
Crisis and Responses: The Federal
Reserve in the Early Stages of the
Financial Crisis
Stephen G. Cecchetti
I
n summer 2007, U.S. and global financial markets found themselves facing a
potential financial crisis, and the U.S. Federal Reserve found itself in a
difficult situation. It was becoming clear that banks and other financial
institutions would ultimately lose tens or even hundreds of billions of dollars from
their exposure to subprime mortgage market loans. Bank lending is closely tied to
bank capital or net worth—specifically, bank regulators require that loans not
exceed a certain multiple of capital. Thus, the Federal Reserve faced the danger of
a sharp contraction in credit and bank lending in a way that threatened a deep
recession or worse.
When this kind of event happens, the job of the central bank is to assure that
financial institutions have the necessary funds to conduct their daily business; that
they have the “liquidity” they need to make timely payments and transfers. Modern
financial institutions need to replenish their funding every day. In the United States
alone, literally trillions of dollars are transferred between banks each day to support
the $50 trillion credit outstanding in the economy as a whole. Commercial banks
require funds to initiate the mortgages, auto loans, and credit card debt they then
sell into financial markets, while investment banks finance much of their activity
with daily borrowing.
In the early stages of the crisis, the situation often arose in which a wellcapitalized bank was forced to make sudden large loans based on previously
committed lines of credit. In this circumstance, central bank actions can ease
y Stephen G. Cecchetti is Economic Adviser and Head of the Monetary and Economic
Department, Bank of International Settlements, Basel, Switzerland. At the time this essay was
written, he was Barbara and Richard M. Rosenberg Professor of Global Finance, International Business School, Brandeis University, Boston, Massachusetts, and a Research Associate, National Bureau of Economic Research, Cambridge, Massachusetts. His e-mail address
is 具stephen.cecchetti@bis.org典.
52
Journal of Economic Perspectives
liquidity constraints by supplying banks with the funds they need in the short term.
In fall 2007, the Federal Reserve provided short-term funding liquidity by, in effect,
allowing banks to exchange their holdings of Treasury securities for cash. This
policy enabled the banks to meet the credit line commitments they had outstanding.
However, it became clear in October and November 2007 that traditional
central bank tools were of limited use. Realizing these failings, Fed officials created
innovative, new lending procedures in the form of the Term Auction Facility and
the Primary Dealer Credit Facility, as well as changed their securities lending
program, creating the Term Securities Lending Facility. I describe how these new
systems work, how each is intended to inject liquidity into the financial system,
providing some time for institutions and markets to stabilize.
But before getting into the details, it is important to understand that there is
a limit to what central bank tools can accomplish. When losses erode bank capital
to the point where regulatory constraints become binding, private lending can only
begin to grow again when capital has been replenished. A return to normalcy
requires that banks either raise new equity from outside investors or receive a
transfer from the fiscal authorities. Since the Fed is fundamentally not in the
business of making such transfers, its ability to ease capital constraints is limited.
However, as we will see, some of the less-traditional Fed actions taken during the
crisis had a fiscal flavor to them and may be interpreted as an indirect attempt to
subsidize banks in need.
The paper begins with a discussion of the traditional tools of monetary policy
and how they work, using the balance sheet of the Federal Reserve as a device for
understanding the conduct of monetary policy. We then turn to the early stages of
the financial crisis, describing the symptoms and speculating about the causes, and
lay out the early rounds of the policy responses used by the Federal Reserve. This
essay was written in Spring 2008 and only describes events and responses through
May 2008. While these policies may have helped in reducing the risk of a short-run
financial crisis, Federal Reserve policies have not been able to keep the problems
in the financial system from having an effect on real economic activity. This
outcome is unsurprising. Financial intermediaries did in fact incur substantial
losses, and changes in central bank lending practices will not overturn this fact.
The Federal Reserve Balance Sheet and Policy Tools
Monetary policymakers affect the quantity of funds available in the financial
system by manipulating the assets and liabilities held by the central bank, which in
turn affects the price of those funds—the interest rate. The Federal Reserve
publishes balance sheet information weekly on its website. Table 1 reports a
stripped-down version of the Federal Reserve System’s balance sheet in early July
2007, prior to the onset of the crisis. To highlight the changes that occurred, we
start with a whirl-wind tour of the liabilities and the assets as they existed before the
crisis began. The discussion then turns to basic principles of managing a balance sheet
and how they are related to tools of monetary policy like open-market operations and
Stephen G. Cecchetti
53
Table 1
The Balance Sheet of the Federal Reserve, July 2007
(in billions of dollars)
Assets
Liabilities
Securities
Held outright
Repurchase agreements
Loans
Primary lending
Foreign exchange reserves
Gold
Other assets
Total assets
$790.6
$30.3
$0.19
$20.8
$11.0
$27.5
$880.4
Federal Reserve notes
Commercial bank reserve balances
Liabilities related to foreign official
and U.S. Treasury deposits
Other liabilities
$781.4
$16.8
$42.4
Total liabilities
$846.3
Capital (ⴝ Total assets ⴚ Total liabilities)
$5.7
$34.1
Source: Federal Reserve Statistical Release H.4.1, Table 2, 具www.federalreserve.gov/releases/h41/典; and
quarterly Treasury and Foreign Exchange Report, April–June 2007, Federal Reserve Bank of New York
具www.ny.frb.org/markets/quar_reports.html典.
Note: With the exception of the value of foreign exchange reserves, which is for June, 30, 2007, all
numbers are as of July 4, 2007.
changes in discount rates. In what follows, I will use the unqualified term “bank” to
refer to a commercial bank rather than to the central bank or to an investment bank.
Liabilities: Currency and Reserves
Starting with the liability side of the balance sheet in Table 1, the amount of
currency in circulation represents roughly $2,600 per U.S. resident. Even after
accounting for the underground economy and amounts of currency held by
retailers, this total seems extremely high. But as reported in U.S. Treasury (2006),
one-half to two-thirds is held outside the country. Because currency plays no role in
the episode at hand, we move to the entry for commercial bank reserve balances.
Banks hold reserves at the Fed for three interrelated reasons: 1) they are required
to do so; 2) they need them to do business, so they can meet customer demands for
withdrawals and make payments to other banks; and 3) it is prudent to do so
because reserves act as the bank’s emergency fund, ready in case disaster strikes.
Table 1 shows that in July 2007 the level of reserve balances was $16.8 billion.
This total is relatively small—approximately one-tenth the level held by European
banks in the national central banks of the Eurosystem. U.S. banks keep reserve
balances as low as possible because they traditionally receive no interest on such
reserves, while European banks are paid something close to the overnight interbank lending rate.1
1
On October 13, 2006, the U.S. Congress passed the Financial Services Regulatory Relief Act of 2006
(Public Law 109-351), authorizing the Federal Reserve to pay interest on reserves beginning on October
1, 2011. The Federal Reserve Board has not yet announced whether it will do so, but there is a strong
suspicion it will.
54
Journal of Economic Perspectives
Two additional liabilities appear on the balance sheet in Table 1. The first
concerns deposit accounts that belong either to the U.S. Treasury or to foreign
governments and central banks. These institutions need bank accounts just like any
other person or business, and the Federal Reserve offers them this service. Finally,
the very modest category of “other liabilities” includes deposit balances of international organizations like the International Monetary Fund and the United Nations,
as well as those of federal government agencies such as Fannie Mae and Freddie
Mac.
Assets: Securities Holdings, Loans, and Foreign Exchange Reserves
Moving to the asset side of the balance sheet, the Fed holds securities both
outright and as part of repurchase agreements, or “repos” for short. Securities that
the Fed owns directly are composed entirely of U.S. Treasury bills, notes, and
bonds. Before the financial crisis began, these outright securities holdings comprised about 90 percent of the Fed’s assets.
In July 2007, repos accounted for $30.3 billion, or just 3.4 percent, of total Fed
assets. However, repurchase agreements are extremely important, because they are
the method the Fed uses to adjust the level of reserves in the banking system from
day to day. For example, when one reads that the Federal Reserve Bank of New
York’s Open Market Desk put $38 billion into the banking system on August 10,
2007, it was done with repurchase agreements.
A dictionary-style description of a repurchase agreement goes something like
this: it is a short-term collateralized loan in which a security is exchanged for cash
with the agreement that the parties will reverse the transaction on a specific future
date at an agreed upon price, as soon as the next day. In more intuitive terms,
perhaps the easiest way to think about a repo is as an overnight mortgage (because
a mortgage, like a repo, is fully collateralized). In the same way that you pledge your
house to the bank in exchange for a loan, a financial institution pledges a bond to
the Federal Reserve in exchange for funds—and also promises to reverse the
transaction and provide cash for the bond in the near future.
The Fed carries out these transactions through the Federal Reserve Bank of
New York’s Open Market Desk. The desk engages in repurchase agreements every
morning (usually at 8:30 a.m. or 9:40 a.m.). The quantities normally range from $2
billion to $20 billion dollars. The desk sends out a message to 19 “primary dealers,”
most of which are investment banks, stating the term of the repo and the type of
collateral that it will accept. The primary dealers, the only parties qualified to
participate in these daily operations, send their offers— quantities, prices, and
collateral—and then the New York Fed decides how much to accept. (For a current
list of the primary dealers see 具http://www.ny.frb.org/markets/pridealers_
current.html典). Three types of collateral are allowed under law: U.S. Treasury
Securities, U.S. agency securities (issued by entities like Fannie Mae and the Small
Business Administration), and AAA-rated and insured mortgage-backed securities.
The total quantity of securities offered by the primary dealers (at all interest rates)
averages roughly five times what is accepted for Treasury securities, ten times for
Crisis and Responses: The Federal Reserve in the Early Stages of the Financial Crisis
55
agency securities, and 15 times for mortgage-backed securities. While most offers
are overnight, it is standard to engage in repos with maturities as long as 14 days.
By conducting repos on a daily basis, the Fed accomplishes two things. First, it
keeps a fraction of its assets very short term, ensuring flexibility to expand and
contract the quantity quickly. This allows policymakers to add or drain reserves
from the system immediately if the need arises. Second, by operating every day, the
Fed is in contact with market participants on a regular basis. If short-term funding
markets start to experience strains, the Fed will find out immediately through the
offers it receives from primary dealers in its daily operations.
Loans are the next entry on the asset side of the balance sheet. Historically,
banks have been extremely reluctant to borrow from the central bank. Prior to the
start of the crisis, borrowings averaged less than $200 million per day. Even for the
first seven months of the crisis, from August 2007 through mid-March 2008, the
quantity of discount window borrowing averaged just over $1 billion.
The stigma attached to borrowing from the Fed probably arises from several
sources. Prior to 2003, banks could be admonished by the Fed for overuse of
discount window borrowing, which created a distinct disincentive. Over the years,
the Fed has tried to emphasize that borrowing from the central bank should be a
normal part of business. Even so, banks continue to fear that if they borrow from
the central bank, other banks and financial institutions will draw negative conclusions about their financial strength. Artuç and Demirlap (2007) provide a useful
overview of the modest literature on discount window borrowing.
Continuing on the asset side, foreign exchange reserves are the next entry. As
of June 30, 2007, the Fed held $13.1 billion in euro-denominated assets and $7.7
billion in Japanese yen in a combination of marketable securities and deposit
accounts at foreign institutions. The Federal Reserve holds half of the foreign
exchange reserves of the United States, with the other half on the balance sheet of
the U.S. Treasury’s Exchange Stabilization Fund. In the rare event of an intervention in the foreign exchange market, the quantity is evenly split between the two.
The next entry is gold. This item represents the Treasury’s gold stock held in
Fort Knox, which is carried on the books at a fixed value of $42.22 per troy ounce.
Finally, the sizeable “other assets” category includes a variety of items: the land,
physical premises, and operating equipment of the Federal Reserve banks; special
drawing rights certificates issued by the International Monetary Fund; coins issued
by the U.S. Treasury; accrued interest on U.S. Treasury securities held outright; as
well as items in process of collection associated with the Fed’s check clearing
business.
Two General Principles of Balance Sheet Management
Two general principles are associated with the management of a central bank’s
balance sheet. First, policymakers control its size. If the Federal Reserve wishes, it
can create liabilities to purchase additional assets. Open market operations work in
this way: To purchase a security, the Fed creates a reserve liability, crediting the
deposit account of a commercial bank. The central bank can expand its liabilities
without limit—although an expansion of liabilities will reduce the price of those
56
Journal of Economic Perspectives
liabilities, which is the interest rate. In other words, a change in the quantity of
liabilities and assets can affect the level of the risk-free interest rate by altering the
quantity of reserves supplied to the banking system.
Second, the central bank controls the composition of the assets on its balance
sheet. Given the overall quantity of assets it wishes to hold, the Federal Reserve can
decide whether it wants to hold Treasury securities, foreign exchange reserves, or
other assets. Changes in the composition of central bank assets will not affect the
risk-free interest rate, but they have the potential to influence relative prices— one
currency relative to another or one bond relative to another— by changing the
relative supply or desirability of holding one specific asset over another. Within
certain legal limits, the Fed can adjust the composition of its assets along various
dimensions like the maturity structure of its portfolio and the exact bonds that it
owns. Sterilized foreign exchange intervention, where a central bank sells a bond
denominated in one currency and uses the proceeds to buy a bond denominated
in another currency, is a classic example of a decision related to the composition,
but not the quantity, of the assets that the central bank holds.
Open Market Operations and Discount Rates
A textbook treatment of monetary policy focuses on three traditional tools,
each of which is based directly on actions related to the central bank’s balance
sheet: open market operations, balance sheet size, and the federal funds interest
rate target; lending to commercial banks, the fraction of assets held as loans, and
the discount rate; and the level of commercial bank reserves, the composition of
liabilities, and the reserve requirement. As I describe in Cecchetti (2008, p. 420),
changes in reserve requirements are not a tool used by the Federal Reserve in the
twenty-first century, so we focus here on the other two tools. The descriptions that
follow describe the state of the world before the financial crisis of 2007–2008 began.
In the case of open market operations, the Federal Reserve’s policymaking
body, the Federal Open Market Committee (FOMC) sets a target for the federal
funds rate—the (market-determined) rate banks charge each other for overnight
loans of the excess reserves they hold at the Fed. Then, through a daily adjustment
of the securities holdings and repurchase agreements on its balance sheet, the
Open Market Desk, as the monopoly supplier of bank reserves, works to keep the
federal funds rate near its desired target.
Commercial banks can borrow from the Fed at what is technically called the
“primary lending rate” and is more commonly known as the “discount rate.” Each
of the 12 Federal Reserve banks has a standing offer to lend to the banks in their
district that they deem to be sound (as measured by supervisory ratings). Before
2003, the primary lending rate was set below the target federal funds rate. From January
2003 up to the start of crisis in 2007, the primary lending rate was one percentage
point, or 100 basis points, above the target federal funds rate. As long as a bank is
financially sound and willing to pay the penalty interest rate, it can receive a loan. A
borrowing bank can re-lend the borrowed funds to another bank, if it wishes to do so.
Lending through the “discount window” is designed both to provide funds at
the end of the day, allowing banks to meet their payment obligations without
Stephen G. Cecchetti
57
overdrawing their reserve account, and also to enable institutions to borrow against
collateral that the market will not otherwise finance. The second of these purposes
is associated with the classic lender-of-last-resort function.
Discount borrowing is collateralized, which means that the borrowing bank
must have assets of sufficient value that, in the event of default, the Federal Reserve
will not suffer a loss. The Federal Reserve will accept virtually anything as collateral.
In one case in 1985, the Fed lent the Bank of New York $23 billion and took
the entire bank— buildings, furniture, and all—as collateral (Cecchetti, 2008,
p. 336). For details on the pledging and valuation of collateral, see 具http://
www.frbdiscountwindow.org/index.cfm典.
Since both open market operations and discount lending involve changes in
the Fed’s balance sheet that result in expansion or contraction of commercial bank
reserves, they are often presented as different tools with identical effects. But there
are two important practical differences between them. First, any bank can borrow,
while only 19 primary dealers can participate in open market operations. Second,
the Federal Reserve allows a discount loan to be collateralized by a very broad range
of assets, while only a narrow set of very high quality securities qualify for repurchase in regular open market operations.
The Crisis Hits
A complete chronology of the recent financial crisis might start in February
2007, when several large subprime mortgage lenders started to report losses. It
might then describe how spreads between risky and risk-free bonds—“credit
spreads”— began widening in July 2007. But the definitive trigger came on August
9, 2007, when the large French bank BNP Paribas temporarily halted redemptions
from three of its funds because it could not reliably value the assets backed by U.S.
subprime mortgage debt held in those funds. When one major institution took
such a step, financial firms worldwide were encouraged to question the value of a
variety of collateral they had been accepting in their lending operations—and to
worry about their own finances. The result was a sudden hoarding of cash and
cessation of interbank lending, which in turn led to severe liquidity constraints on
many financial institutions.
The contraction in the supply of short-term funds caused overnight interest
rates in Europe to shoot up, and the European Central Bank responded the same
day with the largest short-term liquidity injection in its nine-year history—€94.8
billion ($130 billion at the time) worth of overnight repos. The following day, as
these overnight repurchase agreements expired, the operation to renew them was
two-thirds the size—a still very large €61.1 billion. Meanwhile, the Open Market
Trading Desk of the Federal Reserve Bank of New York used one-day repurchase
agreements to inject $24 billion in reserves into the U.S. banking system on
Thursday; and when those expired on Friday, the desk upped the amount to $38
billion for the weekend.
Symptoms of the turmoil in financial markets that began in August 2007 are
58
Journal of Economic Perspectives
Figure 1
Spread between 3-month LIBOR and 3-month Expected Federal Funds Rate,
January 2007 to May 2008, Daily
120
100
Basis points
80
60
40
20
0
8
/0
29
4/ 08
/
31
3/ 08
/
27
2/ 08
/
29
1/ /07
8
/2
12 /07
7
/2
1 1 /07
9
/2
10 07
/
28
9/ 07
/
30
8/ 07
/
31
7/ 07
/
02
7/ 07
/
01
6/ 07
/
02
5 / 07
/
30
3/ 0 7
/
01
3 / 07
/
31
1/ 07
/
02
1/
Source: LIBOR data are from the British Bankers’ Association 具www.bba.org.uk典. The expected federal
funds rate data are from Exhibit 2.10 of Greenlaw, Hatzius, Kashyap, and Shin (2008). Note that because
the LIBOR rate is determined at 11a.m. U.K. time, which is 5 a.m. Eastern U.S. time, I plot the expected
federal funds rate on date t minus LIBOR at t ⫺ 1. This avoids spurious spikes that would occur on dates
when the Federal Open Market Committee made unexpected, inter-meeting changes in the target
federal funds rate.
evident in a variety of places. One place to look is the interbank lending market.
U.S. commercial bank borrowing exceeds $2 trillion. To remain flexible in adjusting the size and composition of assets they hold, banks tend to keep most of this
short term. As a result, if banks suddenly become unwilling to lend, problems arise.
Distress in this market is evident from the behavior of the London Inter-Bank
Offered Rate. LIBOR is the benchmark rate on interbank lending set by a group of
16 large banks each morning. It is a key interest rate used to price various consumer
and business loans, including various kinds of mortgages.
LIBOR can be compared to the federal funds market because both involve
uncollateralized loans. Figure 1 plots the difference between the three-month
fixed-rate LIBOR and the expected interest rate that would accrue from repeatedly
rolling over a loan at the overnight federal funds rate for three months (known as
an Overnight Indexed Swap or “OIS”). The divergence between these two rates is
typically less than 10 basis points. This small gap arises from an arbitrage that allows
a bank to borrow at LIBOR, lend for three months, and hedge the risk that the
overnight rate will move in the federal funds futures market, leaving only a small
residual level of credit and liquidity risk that accounts for the usually small spread.
Crisis and Responses: The Federal Reserve in the Early Stages of the Financial Crisis
59
Figure 2
Spread between U.S. Agency and Treasury Securities, January 2007 to May 2008, Daily
100
90
80
Basis points
70
60
50
40
30
20
10
0
8
8
8
/0
02
4/
/0
02
3/
8
/0
02
2/
07
07
/0
02
1/
2/
/0
12
7
07
2/
/0
11
2/
/0
10
7
/0
02
9/
7
/0
7
/0
02
8/
02
7/
7
7
7
7
7
/0
/0
02
02
6/
5/
/0
02
4/
/0
02
3/
/0
/0
02
02
2/
1/
Source: Citigroup, Inc.
Note: Based on averages across a broad spectrum of available maturities of large, liquid, issues of
government-sponsored enterprise and agency debt.
But on August 9, 2007, the difference between these two interest rates jumped to
40 basis points. The “LIBOR spread” then fluctuated between 25 and 106 basis
points through fall 2007.2
A second symptom of the financial crisis comes from looking at the average
difference between U.S. government agency securities—those issued by Fannie
Mae, Freddie Mac, and the like—and U.S. Treasury securities of equivalent maturity plotted in Figure 2. Normally the securities from government agencies are
viewed as only very slightly more risky and less liquid than Treasury issues themselves. But again, starting in August 2007, the gap doubled from its typical range of
15 to 25 basis points to more than 40 basis points. As the crisis intensified through
the fall and winter, the so-called “agency spread” exploded to more than 90 basis
points in March 2008. The change represented a “flight to quality,” in which
2
This arbitrage is imperfect for an important reason that could explain at least a part of the increased
spread. The problem is that the federal funds futures market allows a potential lender to hedge
movements in what is known as the “effective” federal funds rate—that is, the quantity-weighted average
of transactions in the overnight interbank lending market during the day. A bank cannot, however,
guarantee that it will be able to borrow at the effective rate. Importantly, since August 9, 2007 the
intra-day volatility of the federal funds rate has risen by a factor of four—from 5 to 20 basis points. As
a result, the risk of financing a three-month loan by borrowing overnight for three months rose
substantially, suggesting that this “term spread” would rise as well.
60
Journal of Economic Perspectives
investors and financial institutions shunned everything but U.S. Treasury securities
themselves.
In both of these examples—the LIBOR spread and the U.S. government
agency spread—the relevant market threatened to become almost functionally
illiquid. The banks that participate in what is called “fixing” the LIBOR rate have
no obligation to borrow or lend at those rates. No data exists on the quantity of
interbank lending, but anecdotal evidence strongly suggests that few loans were
actually occurring at these rates. Similarly, the market for securities of U.S. government agencies threatened to become illiquid.
In one market, the market for commercial paper, data on both prices and
quantities are available. Figure 3 plots the behavior of 30-day commercial paper
interest rates and quantities outstanding beginning in June 2007. Panel A compares
the evolution of the rate on high-grade, AA-rated, nonfinancial commercial paper,
issued by large corporations like General Electric and Coca Cola, with that of
asset-backed commercial paper (often abbreviated as “ABCP”). Asset-backed commercial paper is issued by firms that hold things like the securities backed by
mortgage pools as assets—and thus the risk premium on asset-backed commercial
paper can give us a sense of beliefs about losses that may occur in real estate
markets. By June and July 2007, asset-backed commercial paper was commanding
a premium of 5 basis points. In mid-August 2007, the premium on asset-backed
commercial paper had risen to 86 basis points, and in early December 2007, it
peaked at more than 150 basis points.
In terms of quantities, the amount of commercial paper grew at a nearly 10 percent average annual rate from 2002 to 2007, reaching $2.2 trillion at the start of the
crisis. Asset-backed commercial paper accounted for more than half of this total in
August 2007, peaking at nearly $1.2 trillion. On any given day, more than two-thirds of
all outstanding commercial paper has a maturity of five business days or less. Starting
in mid-August, borrowers had trouble rolling over maturing issues. The quantity of
commercial paper outstanding dropped precipitously, falling by nearly $300 billion in
the first two months of the crisis and by a total of $400 billion by the end of 2007. Panel
B of Figure 3 shows that the decline is entirely accounted for by the fall in asset-backed
commercial paper outstanding. To guard against short-term illiquidity of specific
institutions, issuers of commercial paper typically have available to them backup lines
of credit with banks. During the last five months of 2007, total commercial bank credit
extended rose by $575 billion (according to the Federal Reserve Board’s H8 statistical
release, page 2, line 5), more than offsetting the fall in commercial paper, as issuers
called upon these bank credit lines.
Finally, the market for repurchase agreements also exhibited symptoms of the
financial crisis. Large financial institutions that hold various types of assets use
repos to finance their short-term liquidity needs—and those needs have grown
astronomically. For the 19 investment banks that serve as primary dealers, repos
outstanding rose by a factor of four over the last decade, reaching $4 trillion at the
dawn of the crisis in August of 2007. As the crisis moved into early 2008, this repo
market began experiencing severe disruptions. The overnight rate on Treasury
securities plotted in Figure 4 illustrates the change. This interest rate is what a
Stephen G. Cecchetti
61
Figure 3
Commercial Paper, June 2007 to May 2008
A: 30-Day Interest Rates
6.5
6
5.5
Percent
5
4.5
4
3.5
AA nonfinancial commercial paper
AA asset-backed commercial paper
3
2.5
2
1.5
8
/0
16 8
5/ 2/0
0 8
5/ 8/0
1 8
4/ 4/0
0 08
4/ /
21 8
3/ 7/0
0 8
3/ /0
22 8
2/ 8/0
0 8
2/ /0
25 8
1/ 1/0 7
1 0
1/ 28/ 7
/ 0
12 4/
/1 07
12 30/ 7
/ 0
11 6/
/1 07
11 02/ 7
/ 0
11 9/
/1 07
10 05/
/ 7
10 /0
21 7
9/ 7/0
0 7
9/ /0
24 7
8/ 0/0
1 7
8/ /0
27 07
7/ 3/
1 7
7/ /0
29 7
6/ 5/0
1
6/ /07
1
6/
B: Quantities Outstanding
2250
2000
$ Billions
1750
Total commercial paper
1500
Asset-backed commercial paper
1250
1000
750
/
07
08
8
8
/0
09
5/
4/
08
/
13
08
/0
12
3/
2/
07
9/
/
16
1/
7
07
0
1/
/1
12
/2
11
07
4/
/2
10
07
9/
07
07
/
26
9/
2
8/
/
01
8/
7
0
6/
/
04
7/
0
6/
Source: Board of Governors of the Federal Reserve System, 具www.federalreserve.gov/releases/cp/典.
Note: Interest rate data are daily, and quantity data are weekly. The data are not seasonally adjusted.
62
Journal of Economic Perspectives
Figure 4
Overnight Treasury Securities Repo Rate
4.0
Overnight repo rate
Target federal funds rate
3.5
Rate (%)
3.0
2.5
2.0
1.5
1.0
0.5
0.0
8
/0
11
8
/0
8
/0
8
8
/0
21
28
04
4/
4/
3/
3/
/0
14
8
8
/0
07
3/
3/
/0
29
8
8
/0
22
2/
2/
/0
15
8
/0
8
/0
01
08
2/
2/
2/
Source: Federal Reserve Bank of New York.
borrower has to pay for an overnight loan collateralized by a U.S. Treasury security.
Because a repo is collateralized and a federal funds loan is not, the repo rate is
normally between 5 and 10 basis points below the federal funds interest rate. But
at the end of February 2008, with the federal funds rate target at 3 percent, the
Treasury repo rate fell to 1.95 percent—a difference of 105 basis points. On March
19, 2008, investors and financial institutions became so desperate to get their hands
on U.S. Treasury securities that they were willing to hold them with virtually no
compensation at all, and the repo rate fell to 0.20 percent.
These pieces of evidence suggest a chronology: Starting in early August 2007,
fear led to hoarding of cash and a broad increase in risk premia. Matters then
seemed to improve from late September until the end of November, when it
became clear that financial institutions were experiencing large losses. A compilation of these losses from news reports in late 2007 suggested that commercial and
investment bank losses in the subprime mortgage market had surpassed a combined total of $150 billion, while estimates several months later exceeded $400
billion (Greenlaw, Hatzius, Kashyap, and Shin, 2008). Risk spreads widened again
in December 2007 and continued to deteriorate with investors’ and institutions’
continued flight to safe securities into the winter of 2008.
Why did the interbank lending market dry up? There are two possible explanations for the unwillingness to lend. One is that lenders perceived a substantial increase
in credit risk—that is, an increased risk that more borrowers will default. The alternative is that banks that normally would have been willing to lend faced a combination of uncertainties and constraints related to the size of their own balance
Crisis and Responses: The Federal Reserve in the Early Stages of the Financial Crisis
63
sheets. This concern could have arisen from fears about both involuntary lending
that banks might be forced to make because of prior commitments on credit lines,
and fears of the declines in the value of assets that the banks were holding.
It is difficult to gauge the relative importance of these explanations. However,
evidence in both McAndrews, Sarkar, and Wang (forthcoming) and Bank of
England (2008) suggest that, through the end of 2007, funding problems associated with concerns over bank capital were the dominant concern, but that starting
in early 2008 concerns over borrower creditworthiness were the cause of the
continued high risk premia.
Consistent with this conclusion is that, through fall 2007, banks increased
credit extensions dramatically—from August 8 to December 26, 2007, bank credit
rose $544 billion, or more than 6 percent. After that time, bank credit outstanding
increased only $60 billion over the first eight weeks of 2008. Although we only have
anecdotal evidence to back this up, it is plausible that the burst of lending in the
fall of 2007 was associated with lines of credit that banks had extended as insurance
to the entities that had been issuing asset-backed commercial paper but who were
not able to issue such paper because of a lack of buyers after August 9.
Added to the pattern of bank lending is the fact that by mid-2007, severe
difficulties were arising in valuing a broad array of complex securities. Subprime
mortgages had been combined into broader securities and then carved up into
complex financial products. Investors had relied on the ratings agencies such as
Moody’s and Standard and Poor’s to certify that parts of resulting asset pools had
lower or higher risks. However, starting in fall 2007, rating agencies steadily
downgraded their views on the credit quality of these instruments. For example, on
January 30, 2008, Standard and Poor’s issued a single report in which it downgraded over 8,000 securities backed by assets of various kinds (at 具http://
www2.standardandpoors.com/spf/pdf/media/subprime_action_rmbs_cdo.pdf 典).
This pattern of uncertain and diminishing values is characteristic of a financial
crisis, and it has important consequences. Bankers that do not know the value of their
own balance sheets are also unsure of their lending capacity. In addition, increased
volatility in markets drove up conventional measures of risk, forcing banks to move
toward less risky assets and to contract the overall size of their balance sheets.
As the financial crisis progressed into winter and spring 2008, previous lending
commitments must have eventually exhausted their limited lifetimes, hence the
drop in bank credit growth. In addition, problems with asset valuations must have
been to some extent resolved— or at least were coming into clearer focus. Thus, at
some point, the overriding consideration in the refusal of banks to lend to one
another must have become the concern over credit risk—that is, the risk that
borrowers would fail to repay.
Federal Reserve Interventions
Under the Federal Reserve Act (section 2A, at 具http://www.federalreserve.
gov/GeneralInfo/fract/典), “The Board of Governors of the Federal Reserve System
64
Journal of Economic Perspectives
and the Federal Open Market Committee shall maintain long run growth of the
monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum
employment, stable prices, and moderate long-term interest rates.” What tools did
Federal Reserve policymakers have to “maintain long run growth of the monetary
and credit aggregates” starting in fall 2007? Is there anything that the Fed can do to
bring the LIBOR spread down or to help provide banks with financing at maturities of
roughly three months? Can officials prevent liquidity constraints from causing asset
sales that further depress prices and cause the crisis to broaden and deepen?
Table 2 divides the policy actions taken by the Fed between August 9, 2007, and
May 2, 2008, into two groups: those that fit the conventional textbook definitions
of aggressive monetary policy and those that do not. The first group, listed in the
top panel of the table, is comprised of the seven cuts in the target federal funds rate
totaling 31⁄4 percentage points. Each of these comes with a cut in the primary
(discount) lending rate.
It would seem that the standard monetary tools—the cut in the cost of discount
borrowing and the increase in the term of the loans announced on August 17, 2007,
followed by cuts in the federal funds rate target starting in mid-September 2007—
should have addressed the problem. After all, offering discount loans of up to 30
days at an interest rate only 50 basis points above the federal funds target should
have given banks access to the liquidity they needed to carry on their day-to-day
operations. Lowering the federal funds rate should help banks profit from their
“maturity transformation” business of issuing short-term liabilities and making
longer-term loans.
While these steps may have aided banks a bit, there was no return to
normalcy. Moreover, the problems of risk and credit shortage—as illustrated by
the rising spread between U.S. agency and Treasury securities in Figure 2—worsened through late fall 2007 and early winter 2008. Thus, Fed officials began a
series of less conventional actions that are not in the current textbook descriptions of monetary policy (although they will presumably be in future textbooks!). These actions include reducing the premium on primary (discount)
lending from 100 to 50 and then to 25 basis points above the federal funds rate
target, as well as an increase in the term of the lending from overnight to 30 and
then 90 days; the creation and then enlargement of the Term Auction Facility
(TAF); the extension of $24 billion in credit to the European Central Bank and the
Swiss National Bank, eventually raised to $62 billion; the change in the pre-existing
securities lending program to initiate the Term Securities Lending Facility (TSLF);
extension of credit to primary dealers through the newly created Primary Dealer
Credit Facility (PDCF); and the authorization of lending to support the JPMorgan
Chase purchase of Bear Stearns. To appreciate how each of these policies works, we
need to link each one to the Fed’s balance sheet and toolbox discussed earlier.
Term Auction Facility
By late 2007, it was clear that the changes in the discount lending policy put in
place in mid-August were not working. Banks continued to be unwilling to borrow
Stephen G. Cecchetti
65
Table 2
Major Federal Reserve Policy Actions, August 9, 2007 to May 2, 2008
Conventional actions:
Simultaneous cuts in the target federal funds rate and primary lending rate
September 18
October 31
December 11
January 21
January 30
March 18
April 30
50
25
25
75
50
75
25
basis
basis
basis
basis
basis
basis
basis
point
point
point
point
point
point
point
cut
cut
cut
cut
cut
cut
cut
at
at
at
at
at
at
at
regularly scheduled FOMC meeting
regularly scheduled FOMC meeting
regularly scheduled FOMC meeting
an unscheduled FOMC meeting
regularly scheduled FOMC meeting
regularly scheduled FOMC meeting
regularly scheduled FOMC meeting
Unconventional actions
August 9
August 17
December 12
December 17
March 2
March 7
March 11
March 14
March 16
May 2
Increase in the level of temporary open market operations
Cut in primary lending rate from 100 to 50 basis points above the federal funds
rate target; an increase in the term of discount lending from overnight to a
maximum of 30 days
Announced creation of the Term Auction Facility (TAF) and the swap lines
with the European Central Bank and the Swiss National Bank of $20 billion
and $4 billion, respectively.
First TAF auction: $20 billion, 98 bidders
Announced intention to conduct 28-day repos cumulating to $100 billion.
Announced an increase in the size of the TAF from $60 billion to $100 billion
outstanding at any given time.
Announced creation of Term Securities Lending Facility (TSLF) and the
intention to lend $200 billion worth of Treasury Securities to primary
dealers. Increase in the swap lines with the European Central Bank and the
Swiss National Bank to $30 billion and $6 billion, respectively.
Announced approval of loan to Bear Stearns through JPMorgan Chase.
Announced creation of Primary Dealer Credit Facility (PDCF); announced
approval of $30 billion loan to JPMorgan Chase for the purposes of
purchasing Bear Stearns; cut in primary lending rate from 50 to 25 basis
points above the federal funds rate target; an increase in the term of
discount lending from a maximum of 30 days to a maximum of 90 days.
Increase in the size of the TAF to $150 billion. Increase in the swap lines with
the European Central Bank and the Swiss National Bank to $50 billion and
$12 billion, respectively. Expansion in the collateral that can be pledged in
the TSLF to include AAA-rated asset-backed securities including student
loans, credit card debt, and auto loans, as well as securities backed by
residential and commercial mortgages.
Source: Board of Governors of the Federal Reserve System and Federal Reserve Bank of New York, various
press releases. The FMOC is the Federal Open Market Committee.
from the Fed. As a result, problems in the interbank funding market continued.
Figure 1 showed that, through fall 2007, the spread between three-month LIBOR
and the three-month expected federal funds rate continued to rise.
As Federal Reserve officials searched for alternative mechanisms to inject
funds into the banking system, they found themselves reconsidering some procedures first discussed in 2001. During 1999 and 2000, the annual federal budget was
operating in surplus, reducing the quantity of Treasury securities outstanding.
Long-term forecasts at the time suggested that the level of government debt might
66
Journal of Economic Perspectives
decline in a way that there would be an insufficient supply of federal government
securities to supply the assets of the Federal Reserve. Federal Reserve System staff
undertook a study of possible alternative operating procedures. One of the suggestions
was to supply reserves through an auction mechanism (Federal Reserve System Study
Group on Alternative Instruments for System Operations, 2002, Chapter 3). In
December, this procedure was implemented in the form of the Term Auction Facility.
The idea behind the Term Auction Facility was to remove the stigma associated
with discount borrowing and in that way to get reserves to banks that needed them. As
the name suggests, the TAF auctions funds for a certain term. Through it, the Fed
started lending reserves in substantial quantities for relatively long periods—initially
$20 or $30 billion, then $50 billion, and then $75 billion per auction for terms of 28 or
35 days. Importantly, as the Fed increased lending, it reduced its outright securities
holdings in equal measure, leaving the total size of the Fed balance sheet unaffected.
Here is how the Term Auction Facility works: Any of the more than 7,000-plus
commercial banks in the country can bid in the auction, stating what interest rate
it will pay for what quantity of funds. The minimum bid rate is determined by the
expected federal funds rate in the market over the term of the auction. An
individual bank’s bid cannot exceed 50 percent of the value of the collateral that
it has available for discount window borrowing. A bank receiving funds cannot
prepay, so if the loan turns out to be expensive because interest rates fall during the
term of the loan, the borrower is stuck with it (for a description, see 具http://
www.newyorkfed.org/markets/Understanding_Fed_Lending.html典).
The procedures of the Term Auction Facility—including the choice of a
uniform- or single-price auction, the restriction that no bidder can be allocated
more than 10 percent of the total being auctioned, and the fact that settlement
occurs two days after the date of the auction— helps to ensure anonymity for the
banks and that the bidders will not be branded as being in desperate need of
immediate funds (Armantier, Kreiger, and McAndrews, 2008). As a result, banks
have been willing to make use of the auction in a way they have refused to do with
the more traditional “discount window” or primary credit facility.
Starting in December 2007, the auctions were held twice a month, with total
reserves supplied rising to $150 billion by the beginning of May 2008. Between 52 and
93 banks participated in the first dozen auctions and the total quantity bid was just less
than twice the total quantity of funds offered. With only a few exceptions, the interest
rate paid was near or below the expected primary lending rate.3
There is some evidence that the Term Auction Facility helped at first to reduce
the spread shown in Figure 1. The Term Auction Facility started its auctions in
mid-December. Figure 1 shows that the difference between the three-month
3
The Federal Reserve’s weekly balance reports Term Auction Facility lending separately by Federal
Reserve District. Roughly two-thirds of the loans are going to banks in the New York district, the location
of most U.S. subsidiaries of foreign banks. This outcome is at least consistent with the possibility that the
Term Auction Facility loans are going primarily to European banks. See the line labeled “Term Auction
Credit” in Table 3 of the H.4.1 weekly release.
Crisis and Responses: The Federal Reserve in the Early Stages of the Financial Crisis
67
LIBOR and the three-month Treasury bill rate declines sharply from early December 2007 until mid-February 2008.
It may seem surprising that the Term Auction Facility would succeed, because
all the auctions do is change the composition of the Fed’s assets leaving the quantity
unaffected. Specifically, the Term Auction Facility involves a shift from securities,
held either outright or in repurchase agreements, to loans. Such a shift carries no
implication at all for the federal funds target rate. A widespread belief, built on past
experiences, has been that changes in the composition of the Fed’s assets have little
or no real effect.4 For example, during the early 1960s, the Fed attempted to reduce
the gap between short-term and long-term interest rates (that is, flatten the yield
curve) by selling short-term Treasury bills and buying long-term Treasury bonds in
what came to be called “Operation Twist.” As Volcker (2002) discusses, this seemed
to have little or no effect. Sterilized foreign exchange intervention, whereby the
central bank sells securities denominated in one currency and buys securities in
another—something the United States has not done since September 22, 2000 —is
another example of a policy where there is a broad consensus that such portfolio
shifts in and of themselves have little or no effect.
But during fall 2007, central banks became aware of something on which they
had not previously focused. While well-established mechanisms existed for injecting
reserves into a country’s financial system, officials had no way to guarantee that the
reserves would reach the banks that needed them. In the United States, standard open
market operations can put reserves into the hands of 19 primary dealers— but this
does not mean that the funds will then be distributed across the banking system.
The problem turns out to be particularly acute when the banks that are short dollar
reserves are not American banks. This insight provided the rationale for the foreign
exchange swaps in which the Fed supplied the European Central Bank and Swiss
National Bank with dollars, which those two central banks went on to auction to
their banks. Thus, perhaps the Term Auction Facility operated to reduce the
difficulties of specific institutions that were having particularly acute problems.
But the Term Auction Facility does more than merely distribute funding to the
banks that need it. The rules of the Term Auction Facility allow banks to pledge
collateral that might otherwise have little market value. Under the rules of the
auctions, TAF loans must be over-collateralized by at least a factor of two, but in
reality the Fed is taking collateral at a price that is almost surely above its actual
market price (Tett, 2008). The result is two-fold. First, liquidity reaches places
where it wasn’t going on its own, which helps to address potential liquidity constraints on individual institutions; and second, banks gain the time they need to
value the assets they have. This action has a fiscal policy flavor, as it has the potential
to provide a capital subsidy to borrowing banks.
Recalling that the officials implemented the Term Auction Facility in the
4
Taylor and Williams (2008) argue that the Term Auction Facility has been ineffective as they find no
impact on the LIBOR– expected federal funds rate spread on the day of banks’ bid for funds in the
auction. By contrast, McAndrews, Sarkar, and Wang (forthcoming) suggest that there was an impact, but
it was on the day of the auction announcement.
68
Journal of Economic Perspectives
hopes of reducing the gap between the three-month LIBOR and the three-month
expected federal funds rate, we can see from Figure 1 that it had a limited impact.
After the spread fell from over 100 basis points in early December 2007 to less than
30 basis points in late January 2008, stress increased again in February 2008. By
March 2008, this spread once again exceeded 70 basis points. The Federal Reserve
then increased the size of the Term Auction Fund, but as of spring 2009, this
particular spread remained elevated.
Term Securities Lending Facility
In winter 2008, a simmering problem hit the financial system with full
force: U.S. Treasury securities of all varieties became extremely scarce. The
primary symptom of this is the dramatic decline in the interest rate on
repurchase agreements collateralized by U.S. Treasury securities plotted in
Figure 4. As noted earlier, in mid-March 2008 this rate fell to 0.20 percentage
points. Investors were willing to hold U.S. Treasury securities with virtually no
compensation.
In response to this extreme flight to quality, the Federal Reserve showed its
capacity for innovation yet again by creating the Term Securities Lending Facility
(TSLF). For several decades, going back to 1969, the Fed has lent Treasury
securities to primary dealers on an overnight basis (Fleming and Garbade, 2007).
This lending seeks to reduce the number of failed securities transactions. Treasury
dealers routinely sell and promise to deliver securities that they do not own,
counting on their ability to procure the right Treasury bill, note, or bond in time
to complete the transaction. Sometimes they miscalculate. However, when a primary dealer is unable to obtain the specific issue it has promised to deliver, that
dealer can go to the Fed in the early afternoon and borrow what it needs. There is
a small fee, and the borrower is expected to return the security the next day.
Since the Fed holds some of nearly every Treasury issue, it can lend whatever is
needed, thereby ensuring that markets function smoothly. In February 2008, for
example, the Federal Reserve held 210 of the 238 distinct Treasury issues
outstanding (exact Fed holdings are available at 具http://www.ny.frb.org/markets/
soma/sysopen_accholdings.html典).
The Term Securities Lending Facility takes this existing lending program
and transforms it in three ways. First, while the traditional program lends
overnight, the new one provides securities for 28 days. Second, the Term
Securities Lending Facility dramatically broadens the collateral accepted. Until
March 2008, lending meant swapping one Treasury security for another. By
contrast, the Term Securities Lending Facility explicitly allows dealers to obtain
Treasury securities in exchange for “AAA/Aaa-rated private-label residential
MBS [mortgage-backed securities] not on review for downgrade” (as announced
at 具http://www.ny.frb.org/newsevents/news/markets/2008/rp080311.html典).5
5
Broadening the allowable collateral beyond that accepted in standard open market operation required
that the Federal Reserve Board invoke Section 13(3) of the Federal Reserve Act, cited in the discussion
of Bear Stearns below.
Stephen G. Cecchetti
69
Finally, the Fed announced its willingness to loan up to $200 billion through the
Term Securities Lending Facility.
Operationally, the Term Securities Lending Facility is an auction where
primary dealers bid for Treasury securities. Potential borrowers of the securities bid
the fee (the interest rate) they are willing to pay, with a minimum that depends on
the collateral acceptable in the auction. In the first auction on March 27, 2008, the
Federal Reserve offered $75 billion face value of securities, received $86.1 billion in
bids and the winning bid was 33 basis points. Thus, for 33 basis points, a dealer
could exchange a residential mortgage-backed security. In mid-March, the benefit
of this was obvious as the repo rate on Treasury’s was several hundred basis points
below that on the mortgage-backed securities. The majority of the succeeding
weekly auctions have been undersubscribed, with the amount offered exceeding
the total quantity for which primary dealers are bidding. Fed officials view this as a
sign of success, because it signals that there is no longer a desperate demand for
Treasury securities.
Like the Term Auction Facility, the securities lending program changes the
composition of the Fed’s asset holdings without affecting their size. While this goal
is not explicit, the Fed is essentially selling Treasury holdings and buying residential
mortgage-backed securities. Like other changes in asset composition, this one is
directed at reducing the relative price of various securities. The Term Auction
Facility was aimed at the gap between term and overnight interbank lending rates;
the Term Securities Lending Facility is directed toward the premium paid to
hold U.S. Treasury securities relative to mortgage-backed securities. Fleming,
Hrung, Keane, and McAndrews (forthcoming) estimate, and Figure 3 confirms,
that the Term Securities Lending Facility was extremely effective in raising the
Treasury repo rate back to levels close to the federal funds rate immediately
upon implementation.
Bear Stearns
On March 13, 2008, it became apparent that the investment bank Bear Stearns
was on the verge of shutting down. A letter one week later, from Securities and
Exchange Commission Chairman Christopher Cox (2008) to Dr. Nout Wellink,
Chairman of the Basel Committee on Banking Supervision, reports that Bear
Stearns’s “liquidity pool”—assets such as Treasury securities that can be quickly
converted to cash— had dropped from $18 billion to $2 billion from Monday to
Thursday. The firm was unable to obtain short-term loans to continue conducting
business. As Cox’s letter emphasizes, in mid-May the firm continued to remain
solvent. Public disclosures in “10-Q filings” confirm this: two weeks earlier, at end
of February 2008, Bear Stearns had had roughly $12 billion in capital to support just
under $400 billion in assets (Bear Sterns, 2008).
The sudden bankruptcy of Bear Stearns would almost surely have been catastrophic. Again, public documents tell us that on February 29, 2008, the firm had
$14.2 trillion of notional value in derivative contracts—futures, options, and
swaps— outstanding with thousands of counterparties. Clearly, the firm was a part
of a complex interconnected network of financial arrangements. If Bear Stearns
70
Journal of Economic Perspectives
had failed, it would then need to sell its assets into a market that lacked the liquidity
to handle it, so prices for those securities could collapse in a way that would affect
the entire financial system.
Since Bear Stearns was not a commercial bank, it had no way to use its
collateral to obtain liquidity from the Federal Reserve. While Fed officials did not
care about Bear Stearns itself, their concern for system-wide financial stability led
them to invoke Article 13(3) of the Federal Reserve Act, which gives the Board of
Governors the power to authorize Federal Reserve banks to make loans to any
individual, partnership, or corporation provided that the borrower is unable to
obtain credit from a banking institution.
On March 14, 2008, the Federal Reserve Bank of New York made a loan
directly to Bear Stearns. Data released on March 20, 2008, combined with press
reports that the loan was repaid on March 17, imply that Bear borrowed approximately $12.9 billion.
By any measure, this action was extraordinary. Not since the 1930s had the Fed
actually made a loan based on Article 13(3). Then, over the next weekend, central
bank officials brokered a deal in which JPMorgan Chase purchased Bear Stearns for
a total of approximately $3 billion. Included in the deal is a loan from the Federal
Reserve Bank of New York.
The Fed’s participation in the deal is described in congressional testimony by
Federal Reserve Bank of New York President Timothy Geithner (2008, Annex III).
The basics are as follows: The Federal Reserve Bank of New York made a $29 billion
10-year loan at the primary lending (discount) rate to a newly formed limited
liability company created to hold $30 billion worth of mortgage-backed securities
previously owned by Bear Stearns. JPMorgan Chase put in $1 billion and assumed
the first loss. Unlike standard discount lending, where the Fed has recourse to go
after the entire borrowing bank’s assets if the pledged collateral is insufficient to
cover the loan, here there is no recourse. This means that if the value of the assets
placed in this new company turn out to be less than $29 billion, the Federal Reserve
would suffer a loss.
But the credit risk associated with this extraordinary loan clearly belongs to the
U.S. Treasury. A March 17, 2008, letter from Secretary of the Treasury Henry
Paulson to Geithner reads, in part, “that if any loss arises out of the special
facility . . . the loss will be treated by the FRBNY as an expense that may reduce the
net earnings transferred by the FRBNY to the Treasury general fund.” The standard
practice is that Federal Reserve System revenue—including interest on its securities
portfolio, net of operating expense—is turned over to the U.S. Treasury. Thus, any
losses arising from the credit facility created to support the J.P. Morgan Chase
purchase of Bear Stearns will reduce the amount of that transfer rather than the
level of the Fed’s capital.
The subsidy implicit in the loan to Bear Stearns is clearly a fiscal, not a
monetary, operation. The Federal Reserve is effectively acting as the fiscal agent for
the Treasury. As an aside, note that actions in which the fiscal authority dictates how
the central bank holds its assets can run the risk of compromising central bank
independence if they become a regular occurrence.
Crisis and Responses: The Federal Reserve in the Early Stages of the Financial Crisis
71
There has been substantial criticism of the Bear Stearns action. Reinhart
(2008) calls it a “bailout” and believes that it has dealt a fatal blow to the Fed’s
ability to act as an honest broker in encouraging private-sector solutions to problems posed by failing institutions, as it did in 1998 when confronting the failure of
Long Term Capital Management (Lowenstein, 2001). At first glance, this accusation of a bailout may seem peculiar, because Bear Stearns’s shareholders and
employees took huge losses, and the price paid by JPMorgan Chase may well be
below Bear Stearns’s net worth. Nevertheless, there is a good argument that the
holders of Bear Stearns’s bonds and other liabilities were in fact bailed out. A
disorderly collapse of the firm could very well have left this group repaid with even
less. As a result, lenders may now feel safe in making loans to other investment
banks, encouraging the borrowers to take more risk than they should.
As for the Fed’s ability to marshal the private sector into cooperating when
circumstances demand, we will have to wait and see. What we can say is that the
decision to extend the Fed’s lending facility to investment banks is likely to lead to
increased regulation and supervision of entities in this business.
Primary Dealer Credit Facility
The evening of March 16, 2008, the Federal Reserve used its Article 13(3)
powers for a second time in three days to create the Primary Dealer Credit Facility.
The 19 primary dealers authorized to participate in daily open market operations
and the Treasury auctions are not banks. They are investment banks and brokers.
None of them have access to either traditional discount loans or the Term Auction
Fund. Starting in mid-March they could borrow from the Federal Reserve. Like
discount loans made to commercial banks, the Primary Dealer Credit Facility allows
borrowers to pledge a relatively broad set of collateral including “investment-grade
corporate securities, municipal securities, mortgage-backed securities and assetbacked securities for which a price is available” (see 具http://www.ny.frb.org/
newsevents/news/markets/2008/rp080316.html典).
The Primary Dealer Credit Facility was immediately popular. For the first three
weeks of its existence, borrowing averaged over $30 billion per day, before gradually declining to around $10 billion by the end of May 2008.
Lending directly to primary dealers serves two objectives: First, it ensures
short-term funding for investment banks. The experience with Bear Stearns, which
sustained a sudden loss of short-term funding but looks to have remained solvent,
made Fed officials realize that lender-of-last resort operations needed to be extended beyond commercial banks (although the full implications of this have yet to
be worked out). Second, the Primary Dealer Credit Facility seeks to reduce interestrate spreads between the asset-backed securities that can be used for collateral in
these loans and U.S. Treasury securities, thereby improving the ability of investors
to buy and sell asset-backed securities in financial markets. Since primary dealers
can now take a relatively broad set of bonds to the Fed and obtain immediate cash,
these securities should be more readily acceptable as collateral in private borrowing
arrangements. If this works, all the Fed should have to do is announce the program;
it should not have to make many, if any, loans.
72
Journal of Economic Perspectives
Looking back at Figure 2, notice that the gap between the interest rate on
government agency and U.S. Treasury securities fell immediately on March 17,
2008, with the creation of the Primary Dealer Credit Facility and continued to
decline, although much more modestly, as the Term Securities Lending Facility
began operation. By the end of May 2008, the spread on government agency debt
(normally 15 to 25 basis points above the Treasury rate) was still 50 basis points—
not great, but better than the spread of 90 basis points in mid-March. There are
several reasons the spread could have fallen at this time. It also could have been
because of the reduction in Fannie Mae’s and Freddie Mac’s capital requirements
announced on March 19 or Goldman Sachs’ and Lehman Brothers’ release of their
quarterly earnings on March 18, 2008. But the new Federal Reserve programs
probably played a role, too.
The Evolution of the Federal Reserve’s Balance Sheet
To understand the comprehensive impact of all of these changes in Fed
operations, we return to the balance sheet. Table 3 shows the evolution of Fed
assets over the nine months from July 2007 to May 2008; and the changes are
enormous.6 Because the liabilities of the Federal Reserve have not changed in any
material way, they are omitted from this table.
Before the crisis, the Fed held nearly $800 billion in securities outright. By the
end of May 2008, that had fallen to almost $500 billion, of which roughly one-fifth
was committed to the Term Securities Lending Facility. Repurchase agreements
used to be around $30 billion; by spring 2008, they exceeded $100 billion. Prior to
December 2007, loans were inconsequential. Nine months into the crisis, the Fed
was lending over $170 billion through a variety of mechanisms. Interestingly, from
the beginning of April, with the discount rate penalty cut to 25 basis points above
the federal funds rate target, discount borrowing skyrocketed, reaching $19 billion
by the end of May 2008. All the while, the size of the Federal Reserve balance sheet
hardly changed, rising at the end of the year to accommodate seasonal demand for
currency, but then falling back. Everything Federal Reserve policymakers had done
was aimed at changing the composition of assets they held, not the size of their
balance sheet.
Conclusion
On August 9, 2007, the global financial system started to crack. Financial
institutions everywhere were forced to confront the reality that their substantial
holdings of mortgage-backed securities were worth less than they thought and had
6
Aid to commercial banks does not end with the changes in Federal Reserve practice. The little-known
Federal Home Loan Banks have been another source of funding. During second half of 2007, these
government-sponsored enterprises provided commercial banks with roughly $230 billion in loans. These
loans are for longer terms than the discount window, are cheaper than discount loans even at a penalty
spread of 25 basis points, and allowed for a broad range of mortgage-based collateral.
Stephen G. Cecchetti
73
Table 3
Federal Reserve Assets on Various Dates
(in billions of dollars)
Securities
Held outright
Uncommitted
Committed to TSLF
Repurchase agreements
Loans
Primary credit
Term auction credit
Primary dealer credit
Foreign exchange reserves
Foreign exchange swaps
Gold
Other assets
Total assets
July 4, 2007
Jan 2, 2008
Mar 19, 2008
May 28, 2008
$790.6
$740.6
$660.5
$30.3
$56.3
$62.0
$384.8
$106.3
$115.0
$4.9
$40.0
$0.12
$80.0
$28.8
$27.3
$0.19
$20.8
$11.0
$27.5
$880.4
$27.3
$24.0
$11.0
$21.6
$925.7
$11.0
$21.0
$890.7
$19.0
$150.0
$10.1
$25.2
$62.0
$11.0
$22.4
$905.8
Source: Board of Governors of the Federal Reserve System, Release H.4.1, various dates.
Note: “TSLF” is Term Securities Lending Facility.
become very difficult to value. Banks’ uncertainty about both their own level of
capital and their ability to borrow made them unwilling to lend. Some financial
intermediaries began to have trouble finding the short-term financing that was
essential for them to carry on their daily business.
Central bank policymakers worked to respond appropriately. Traditional
interest rate instruments proved to be ineffective, so Fed officials innovated in a
number of ways. By lending both cash and securities based on collateral of questionable value, the Fed tried to bring order back to financial markets. The amounts
involved are massive. By the end of May 2008, the Fed had committed nearly
two-thirds of its $900 billion balance sheet to these new programs: $150 billion to
the Term Auction Facility; $100 billion (of the $115 billion total) to 28-day repo of
mortgage-backed securities; a maximum of $200 billion to the Term Securities
Lending Facility (of which $106.3 billion were outstanding); $62 billion to foreign
exchange swaps; $29 billion to a loan to support the sale of Bear Stearns (to be
made at the end of June 2008); and a potentially unlimited amount to the Primary
Dealer Credit Facility.
Was it prudent for the Federal Reserve to refashion its policy tools in this way?
The amount committed by the Federal Reserve has been so large that it is natural
to wonder what would happen if the Fed were to run out of capacity to engage in
transactions that change asset composition without changing the federal funds rate
target. Does the size of the Fed’s balance sheet pose a constraint on the amount of
lending it can do? Ip (2008) reports that Fed officials were concerned about this
possibility and have examined several mechanisms to increase lending capacity
should the Fed need it. The simplest approach is to have the Treasury increase the
size of its deposit account, with the Fed then using the proceeds as they see fit.
74
Journal of Economic Perspectives
There is also the possibility that, even without further legislation, the Federal
Reserve could issue its own debt.
The financial crisis of 2007–2008 raises a number of substantial and difficult
questions: What should policymakers do when prices of leveraged assets boom?
How should central banks respond to declines in the price of risky assets and the
associated increase in risk premia? Should monetary policymakers react to illiquidity in the market for specific assets, and if so, how? When a highly leveraged and
complex financial institution experiences losses, what is the central bank’s responsibility? Should a central bank take on credit risk in its lending operations, or
should this function belong to the U.S. Treasury? Perhaps with experience and
research, the answers to these questions will become clear. Once the crisis is safely
past, we might want to reassess the role of the central bank. But in the financial
crisis of 2007–2008, the Federal Reserve was the only official body that could act
quickly and powerfully enough to make a difference. Given the very real and
immediate dangers posed by the financial crisis that began in August 2007, it is
difficult to fault the Federal Reserve for its creative and aggressive responses.
y Among the vast number of people I spoke with in preparing this essay, I wish especially to
thank David Archer, Peter Fisher, Michael Fleming, Jens Hilscher, Spence Hilton, Anil
Kashyap, Jamie McAndrews, Kim Schoenholtz, Andrei Shleifer, Jeremy Stein, Timothy Taylor,
and Paul Tucker for their insights and comments. An earlier version of this essay was
presented as the Edgeworth Lecture at the 2008 Annual Meeting of the Irish Economic
Association.
References
Almantier, Olivier, Sandy Kreiger, and James
McAndrews. Forthcoming. “The Term Auction
Facility.” Current Issues in Economics and Finance,
Federal Reserve Bank of New York.
Artuç, Erhan, and Sevla Demirlap. 2007. “Discount Window Borrowing after 2003: The Explicit Reduction in Implicit Costs.” Tüsiad-Koç
University Economic Research Forum Working
Paper 0708.
Bank of England. 2008. “Markets and Operations.” Quarterly Bulletin, Q1, 28(1): 6 –24.
Bear Stearns. 2008. “Form 10-Q for the Quarterly Period Ending February 29, 2008.” April 8.
Available at: http://www.bearstearns.com/
sitewide/investor_relations/index.htm.
Cecchetti, Stephen G. 2008. Money, Banking,
and Financial Markets, 2nd edition. New York, NY:
McGraw Hill, Irwin.
Cox, Christopher. 2008. “Letter to Dr. Nout
Wellink, Chairman of the Basel Committee on
Banking Supervision. March 20. http://www.
sec.gov/news/press/2008/2008-48.htm.
Fleming, Michael J., and Kenneth D. Garbade.
2007. “Dealer Behavior in the Specials Market
for US Treasury Securities.” Journal of Financial
Intermediation, 16(2): 204 –228.
Fleming, Michael J., Warren Hrung, Frank
Keane, and James McAndrews. Forthcoming.
“Repo Market Effects of the TSLF.” Federal
Reserve Bank of New York Current Issues in Economics and Finance.
Geithner, Timothy. 2008. “Testimony before
the U.S. Senate Committee on Banking, Housing and Urban Affairs, Washington, D.C.” April
3. http://www.ny.frb.org/newsevents/speeches/
2008/gei080403.html.
Crisis and Responses: The Federal Reserve in the Early Stages of the Financial Crisis
Greenlaw, David, Jan Hatzius, Anil K Kashyap,
and Hyun Song Shin. 2008. “Leveraged Losses:
Lessons from the Mortgage Market Meltdown.”
U.S. Monetary Policy Forum Report No. 2,
Rosenberg Institute, Brandeis International
Business School and Initiative on Global Financial Markets, University of Chicago Graduate
School of Business.
Federal Reserve System Study Group on Alternative Instruments for System Operations.
2002. Alternative Instruments for Open Market and
Discount Window Operations. Federal Reserve
System, December. Available at: http://www.
newyorkfed.org/markets/openmarket.html.
Ip, Greg. 2008. “Fed Weighs Its Options in
Easing Crunch.” Wall Street Journal, April, 9, p.
A3.
Lowenstein, Roger. When Genius Failed. New
York: Random House, 2001.
McAndrews, James, Asani Sarkar, and Zhenyu
Wang. Forthcoming. “The Effect of the Term
Auction Facility on the London Inter-bank
Offered Rate.” Current Issues in Economics and
Finance, Federal Reserve Bank of New York.
75
Paulson, Henry M., Jr. 2008. Letter from
Henry M. Paulson Jr., Secretary of the U.S. Treasury, to Timothy F. Geithner, President of the
Federal Reserve Bank of New York. March 17.
Available at: http://finance.senate.gov/press/
Bpress/2008press/prb040108a.pdf (last page of
the file).
Reinhart, Vincent R. 2008. “Fallout from a
Bailout.” Washington Post, May 22, p. A25.
Tett, Gillian. 2008. “US Banks Quietly Borrow
$50bn from Fed via New Credit Facility.” Financial Times, February 19, pg. 1.
Taylor, John B., and John C. Williams. 2008.
“A Black Swan in the Money Market.” NBER
Working Paper 13943.
Volcker, Paul A. 2002. “Monetary Policy
Transmission: Past and Future Challenges.”
Federal Reserve Bank of New York Economic Policy
Review, May, pp. 7–11.
U.S. Treasury. 2006. The Uses and Counterfeiting
of United States Currency Abroad, Part 3. September. http://www.federalreserve.gov/boarddocs/
rptcongress/counterfeit/counterfeit2006.pdf.